Chapter 7 Valuation Using the Sales Comparison and Cost Approaches Real Estate FIN 331 Fall 2015

Valuation Valuation calculations are required when a: property acquisition is contemplated or a structure is modernized renovated abandoned demolished site is developed property is used as collateral for a loan

Value Concepts Market value: Investment value: Transaction price: Most probable selling price, assuming “normal” sale conditions. Value for the “typical” market participant may not be fundamental value. Investment value: Value to a particular individual (investor). Transaction price: Price actually paid for a specific property

Value Concepts True Value In perfectly competitive markets, transaction prices should be identical to true or intrinsic value Prices are continuously revealed by prices of perfect substitutes (similar dynamics to stock markets) Result: we are all price takers.

Users of Appraisals Buyers Sellers Mortgage Lenders Corporate acquisitions, mergers or dissolutions Courts Divorces Eminent domain cases Settlement of estates Bankruptcy

APPRAISALS Appraisals An unbiased written estimate of the fair market value of a property Appraiser’s final estimate of property value Data upon which the estimate is based Assumptions and calculations used to arrive at the particular estimate

APPRAISALS Why Do We Have To Estimate Market Value? To get an estimate of the probable selling price under current market conditions Lenders require an estimate of market value to make a reasonable mortgage decision Real estate markets are assumed to reflect near perfect competition; the implication is that transaction occur at or very near true (or intrinsic) values Question: Are we all price takers?

Uniform Standards of Professional Appraisal Practice (USPAP) Required & followed by all states & federal regulatory agencies Appraisers are state certified MAI designation? Imposes ethical obligations & minimum appraisal standards Maintained by the Appraisal Foundation Non-profit industry group that Congress (in 1989) charged with setting minimum requirements for all (state) certified appraisers

APPRAISALS: USPAP The Appraisal Process: Uniform Standards of Professional Appraisal Practice (USPAP) Identify the appraisal problem Client & intended uses of appraisal Date of valuation Rights to be valued (fee simple, etc.) Type of value to be estimated: market, insurance, or taxable value? Important assumptions or conditions Determine the required scope of work Time & personal requirements Outline of proposed appraisal report Data & procedures used to complete required tasks

Perform data analysis Collect Data and Describe Property Market Data: general characteristics or region/city/neighborhood Property Data: Site, building and location characteristics Comparable Property data: market information on comparables Perform data analysis Market analysis: Effects of demand & supply Highest & best use; use which is legally/physically/financially permissible Highest & best use as though vacant: considers any possible use Highest & best use as improved: must consider any cost of demolition

APPRAISALS: USPAP Determine value of land: a. Important to value separately from improvements Apply 3 Approaches to Valuation Sales comparison approach Cost approach Income approach

APPRAISALS: USPAP Reconcile indicated values from 3 approaches Weight based on relative reliability of the three approaches Report final value estimate Report writing is an extremely important function Must meet requirements of 1 of 3 reporting options Self-contained report: full narrative description of process Summary report: summary of conclusions, principal points of process Restricted report: minimal discussion, limited to use by client

APPRAISALS: USPAP Three Types of Appraisal Reports Self-contained report Contains full detail & information used to estimate market value Usually takes a full narrative (long & formal) approach Summary appraisal report Summarizes conclusions of the appraisal Majority of data & techniques are kept in appraiser’s work file For homes, usually use “form” instead of narrative reporting option Ex., Uniform Residential Appraisal Report (Exhibit 7-12)

APPRAISALS: USPAP Restricted appraisal report Provides minimal discussion of the appraisal refers to internal file documentation Tells client what the property is worth Client cannot give appraisal to anyone else Usually least expensive of the three options

Sales Comparison Approach to Estimating Market Value Basic Idea: Value of RE can be determined by analyzing the sale prices of similar properties Why? In a competitive market, close substitutes should sell for similar prices Major difficulty? How many truly close substitutes exist & how many of these have sold recently?

Sales Comparison Approach to Estimating Market Value Steps in Sales Comparison Report

APPRAISALS: USPAP Selecting Comparable Sales Must be properties that prospective buyers would consider substitutes Should be arms-length transactions Fairly negotiated prices that occurred under “normal” conditions For example, not a distressed sale Select to minimize required physical and locational adjustments

APPRAISALS: USPAP Data Sources Public records (e.g., county property tax assessor) Multiple listing service Private vendors (title companies, others): CoStar for commercial properties Zillow

Sales Comparison Approach to Estimating Market Value Adjustments to Comparable Sale Prices Convert characteristics of each comparable to an approximation of subject Sequence of adjustments Transactional adjustments: nature of the deal (see list top of page 171) Property adjustments: unique feature of property (ditto) Recent price trends

Cost Approach to Estimating Market Value Procedure Estimated reproduction cost of improvements − Estimated accrued depreciation = Depreciated cost of building improvements + Estimated value of site = Indicated value by the cost approach The Major Assumption?: Cost of creating a property is related to its market value

Cost Approach to Estimating Market Value Two concepts of cost: Replacement cost: Cost to create something of equal utility (functionality) Reproduction cost: Cost of an exact physical replica Complication in application? Methods to estimate replacement cost Quantity survey method Cost per square foot or cubic foot Unit in place

Cost Approach to Estimating Market Value Sources replacement cost estimates R.S. Means www.rsmeans.com Marshall and Swift www.marshallswift.com Consulting firms Builders/contractors

Cost Approach to Estimating Market Value Special Issue of Accrued Depreciation – Commercial Property Difference between replacement cost & market value of improvements Types of accrued depreciation that must be considered: Physical deterioration: Loss in market value due to aging, decay & ordinary use Functional obsolescence: Loss in value due to changes in tastes, preferences, technological innovations, or market standards External (economic) obsolescence: loss of value due to neighborhood changes

Homework Assignment Key terms: Accrued depreciation, Appraisal, Comparable properties, Market value, Property adjustments, Replacement cost, Reproduction cost, Restricted appraisal report, Transactional adjustments Study questions: 2, 3, 4, 7, 8, 12